What’s safe? That’s the question many stock investors are asking early this year.
Global financial markets are experiencing a relatively high level of volatility as 2016 gets underway. China’s economy is slowing down, so stocks sold off strongly there with large spillover effects on all markets.
Where does one turn in such times of trouble? The traditional safe-haven investments are proving unhelpful. Government bonds yield only 1 or 2 percent per year and have not risen in price much. The price of gold is off 10 percent over the past 12 months.
Some investors are returning to real estate despite being hurt in the housing crisis. As of the end of October, The S&P/Case-Shiller U.S. National Home Price Index was 5.2 percent higher year-over-year. The Society of Industrial and Office Realtors’ Commercial Real Estate Index increased 6.8 percent.
Local commercial real estate is also showing strength. The January 2016 Guide to Boise’s Commercial Real Estate Market from Thornton Oliver Keller reports lower vacancies and increased construction in all three categories tracked — office, industrial and retail space.
Before shifting much capital to real estate, or any other so-called “alternative investments,” investors should consider if the recent stock market decline is really that bad. Is the stock market response to slowing economic conditions in China or elsewhere a reasonable adjustment or a sign of impending doom?
It turns out that a large drop in the value of stocks is consistent with only a small change in the forecasted growth rate of earnings. To explain this, financial economists use the discounted cash-flow method of stock valuation. Applying this model to today’s market shows the current situation is consistent with just a slightly lower expected growth rate.
Suppose, for example, that a company’s stock sells for $20 and the company is expected to increase its $1 annual dividend 5 percent each year. Under the discounted cash flow, the expected rate of return for this stock is 10 percent [$1/$20 + 5 percent = 10 percent].
However, if investors think the company can only grow dividends by 4 percent per year, the stock price has to fall to $16.83 in order to earn them the same 10 percent long-run return [$1/$16.83 + 4 percent = 10 percent]. That’s a 16 percent drop in the stock price.
The lesson of this model is that we should expect 10 percent or 20 percent swings in stock prices when investors alter their long-run forecasts just a little. Compared with alternative investments like gold and real estate, stocks aren’t all that risky.
Perhaps the safest thing to do with your stock portfolio is to just stay put.
Peter Crabb is professor of finance and economics at Northwest Nazarene University in Nampa. firstname.lastname@example.org. This column appears in the Jan. 20-Feb. 16, 2016, edition of the Idaho Statesman’s Business Insider magazine.